Inflation is perhaps the least understood phenomenon in all of economics. Once thought to be driven strictly by monetary factors, inflation is seen today as much more nuanced and complicated. Indeed, there is a considerable debate as to its root causes and even how to go about it appropriately measure the.
For most of a generation, economists have been primarily concerned with inflation being too low, while the general public had little interest one way or another. However, all that has changed in recent months; US voters now rank inflation as their top economic concern.
So what happened and what are the prospects for the future?
In March, the Personal Consumption and Expenditure Index (PCE) recorded an astonishing 6.59% year-on-year (YoY) increase. The less volatile Core PCE index rose 5.18%, just below the 40-year high hit the previous month. The surge in inflation has raised the possibility of a structural rise in prices and a “unanchoring” of inflation expectations, although their role in control the price level is far from settled.
To understand the current outlook for inflation, we must first assess how different parts of the economy are contributing to it and how this affects risks going forward. To unravel this conundrum, I examined over 200 categories of goods and services included in the Core PCE index to determine whether inflation is widely distributed or confined to certain categories that wield outsized influence. The methodology is loosely based on research of the Federal Reserve Bank of San Francisco.
To start, I ranked each category of goods and services according to its current rate of inflation compared to what it was before the COVID-19 pandemic. To do this, I ran the following regression for the period from January 2010 to March 2022:
Πhe = αI +βIDhe +Ehe
Πhe = the logarithmic year-on-year change in the price index for category “i” in month “t”
αI = regression intercept
Dhe = a dummy variable that takes the value 1 at the start of the COVID-19 pandemic in February 2020 and 0 otherwise
βI = regression coefficient for the dummy variable
Ehe = regression error term
The ordinate at the origin of the regression, αI, represents the average pre-pandemic inflation rate from January 2010 to January 2020. The coefficient βI is the term at the differential origin and indicates the variation of inflation during the pandemic period. If βI is positive and statistically significant, inflation for category i is higher today than before the pandemic and is therefore classified as above trend. Conversely, if βI is negative and statistically significant, then inflation for category i is lower today than it was before COVID-19 and is therefore below trend. Finally, if βI is not statistically significant, then there is no detectable difference between the two time periods for category i, so it is trending.
In-depth inflation analysis
The table below summarizes the number of categories in each group and the corresponding weight of each group in the Core PCE calculation:
|Number of categories
|weight in the core
|Above the trend
The Above Trend group is made up of 99 distinct goods and services and represents around 55% of the weight of the Core PCE index. As a result, more than half of all spending is currently above trend, putting considerable pressure on consumers’ wallets. In contrast, only 32 categories – only ~13% of spending – are below their pre-pandemic trend, which has not been enough to offset rising prices elsewhere in the economy.
Finally, 78 categories are currently classified as Trending, with inflation in line with what it was before the pandemic. At just 32% of spend, the At Trend categories were unable to stem the upward movement in the general price level.
Goods or services?
The Core PCE can be broadly broken down into 65 categories of goods and 144 categories of services. So, do goods or services contribute more to inflation? To find out, I broke down the trend groups by classification.
The graph below shows the percentage of all categories of goods and services in each of the three trend bands. About 60% of all goods and 40% of all services are currently operating at above-trend inflation. The At Trend group is dominated by services, while its Under Trend counterpart is evenly split.
Percentage of goods and services by trend
Taken together, these numbers imply that goods are the main reason for the recent acceleration in inflation. There are potential upside risks if the At Trend Services categories trend higher. A key determinant to keep services prices anchored will be a sustained recovery in the labor force in service-related sectors such as housing, transport, restaurants and childcare, among others.
To understand where inflation may be headed, I have reconstructed the price indices for the Above Trend, At Trend and Below Trend groups. Even if 99 categories are above the trend, the pace of acceleration may slow down or reverse. This would indicate some short-term decrease in headlines. Conversely, below-trend numbers could trend upwards and move from a negative net contribution to a positive net contribution. This would indicate that the overall numbers could deteriorate further.
The following graph illustrates the year-over-year percentage change in the PCE for each of the price indices. The results show a broad acceleration across classifications. The Above Trend group started to climb at the start of the pandemic and is currently recording an annual change of around 5.90%. The Above Trend categories, on the other hand, showed the most subdued inflation in the pre-COVID-19 period, at around 1% year-on-year for almost 10 years. This rapid spike may indicate significant damage to the supply chains of the Underlying Commodities.
PCE inflation by classification
The At Trend group saw a sharp decline at the start of the pandemic and remained weak for most of 2020, but recovered in 2021 and 2022. The change of 4.4% in February is much higher than the changes that the index experienced before COVID-19, which range between 1% and 2.50%. Indeed, the limited sample size may be all that keeps them trending. This could mean that the At Trend Services categories could experience higher inflation.
The trajectory of the Under Trend group is perhaps the most intriguing of the three. Prior to the pandemic, Under Trend recorded higher inflation than At Trend or Above Trend, with a pre-pandemic range of around 2% to 4% amid considerably higher volatility. At the start of COVID-19, inflation fell precipitously below trend and spent most of 2020 and part of 2021 in negative territory. Outright deflation in the below-trend group has helped contain inflation across the economy, at least for a while. But now the cover may have come off.
Of the three classes, Under Trend saw the most dramatic reversal, rising from -2.4% in February 2021 to 2.4% a year later. Still, it remains below the upper end of its pre-pandemic range. This suggests near-term upside risk as below-trend categories continue to rally.
So how will these trends influence the Core PCE stock? The following graph plots the cumulative contribution of each of the three compartments to the base PCE: the dark blue section represents the contribution above the trend post-pandemic, the dark red section the contribution To the trend and the dark green section the contribution Below the trend. The Core PCE title is coated in gold.
Contributions to Core PCE by classification
Bucket classifications and their color schemes are based on post-pandemic results. A category above the trend today does not mean that its pre-pandemic contribution to the Core PCE was necessarily positive. Indeed, many of the categories operating above the trend today were actually clear detractors for most of the 2010s, which is indicated by the dark blue below zero region from 2011 to 2020 of them.
In March, the Above Trend categories contributed around 3.25% to Core PCE, At Trend at 1.42% and Below Trend at around 0.30%. As expected, very few categories are now acting to offset inflation.
Together, this data provides an expanded and granular picture of where inflation is at its peak and how the underlying trends are developing. They indicate that in almost all categories, inflation is positive and accelerating. The main short-term risk appears to be that Trending categories shift to Above-Trend in the coming months as the sample size expands and the underlying trend is revealed.
Overall, this indicates that the Core PCE should remain high over the next few months. This will have important implications for the stance of monetary policy.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Jeffrey Coolidge
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